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Is J.C. Penney's "Transformation" Already Priced Into Its Stock?

During its latest management meeting day, J.C. Penney (JCP) stock rose more than any other stock I have seen, based on any meeting to explain a new business plan. If the new business plan had been exactly the same, but had not been explained by new CEO Ron Johnson, previously from Apple (AAPL), coming in the wake of Steve Jobs death, I doubt that the stock would have gone anywhere near as high. My views are absolutely with the conventional wisdom on JCP’s future and on the stock price.

The business plan’s operational changes make pretty good sense from a longer-term perspective. Both Kohl’s (KSS) and Macy’s (M) have had good success with private label brands, where they have higher margins, and exclusive brands, and where pricing integrity is better than brands that are available elsewhere. JCP has its brands too, but it has not had the visibility that the Kohls and Macy's brands have had. I believe that that difference has come partly from visibility in the store (where, for instance, I have to look hard to find MNG by Mango, a juniors brand where signage should shout). The other problem is that most of the advertising has been price-oriented, telling consumers about near perpetual “sales.”

The sales are a chicken-or-egg discussion argument. The average customer only comes in four times a year and needs to be brought in by price advertising. Even I was surprised that management said that 75% of sales were made at prices that were at or below 50% off of original ticketed prices.

The easiest start to a fix here is a display of these brands, which will be accomplished by adding separate shops within the store over time. That will also help merchandise the older brands that are generally more visible.

The new store design -- with its core “Town Square” that will somehow bring in customers for what I've heard could be services, or some type of integration of the digital and physical worlds of retailing, or an ice cream cone, or whatever -- may be a positive. Penney’s sales per-square-foot are low enough that diverting the space cannot hurt, if it drives people into the store.

Clearer pricing and reduced promotions would be the real triggers for pivotal change, however. The percentage of advertising spent on publicizing sales and prices is huge, and it detracts from advertising the new brands that JCP has added. Constant promotions also hurt SG&A expenses: sales clerks spend half of their time retagging merchandise prices. That time could be better spent helping customers or reducing prices via hiring less labor.

That will take time. The success of other Every Day Low Prices, or EDLP, programs in the department store sector has been dismal. Now, think back to my most previous note on supermarkets and Procter & Gamble (PG). The trend to lower sales of food is unprecedented and is a barometer of how much consumers are willing to do to save small amounts of money. That shows that this environment is the absolute worst one I can imagine for JCP to change its heavy promotions and go toward a somewhat EDLP (ex clearance sales and one-time monthly promotions) policy.

JCP’s current $41 price is based on the use of what I believe will be sell-side consensus EPS of $2.13 and $3.00 respectively, for calendar years 2012 and 2013, which comes after $1.24 in 2011. It's also based on some credibility to management’s goal of a 13% EBIT margin in 2015, which management says requires a doubling of market share.

Does this make sense when Nordstrom (JWN) does 12%, Kohl’s does 11%, and Macy’s does 9%? How many times do you see companies double market share over such a short period in a mature business? It could happen, but I certainly would not even consider it until after I see management make significant headway on eliminating price promotions, while still maintaining sales at reasonable levels. My bet is that investors will be able to purchase the stock more cheaply as the story plays out and euphoria ends.

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